Valuation-Informed Indexing #46: It’s Not Always a Good Idea to Lower Your Stock Allocation As You Age

June 14, 2011 at 8:36 amby

by Rob Bennett

Buy-and-Holders often advise us to lower our stock allocations as we age. The thinking is that young investors are better able to recover from big losses than are those close to retirement.

It makes a certain amount of sense. But only a certain amount. Take valuations into consideration (Buy-and-Holders do not) and you come to see that, while it is in some circumstances indeed a good idea to lower your stock allocation as you age, it is in other circumstances not necessary and in still other circumstances a bad idea.

Say that when you turn 55 (within 10 years of retirement age), stocks are selling at insanely high prices (as they are today). In those circumstances, the conventional advice is just the ticket. Retirement portfolios almost always fail because of big hits taken in the first 10 years of the retirement. If you get past the first 10 years without taking a big hit, you will have experienced enough growth that it is unlikely that your retirement will ever fail.

So the thing you want to do is to avoid big hits in the first 10 years of retirement. Big hits that remain in place a significant amount of time always come at times of high valuations. So stocks are obviously far more risky at such times. Risk is a bigger concern for retirees than it is for the rest of us. So it makes all the sense in the world for retirees to go with lower stock allocation than most other investors.

The same reasoning applies in the 10 years prior to retirement. By age 55, you will have accumulated a lot of capital. So a big percentage loss is going to hit you hard. And you don’t have many working years remaining in which to refund your plan. So a lower stock allocation really is in order for investors nearing retirement age at times of high stock prices.

The conventional advice does not make nearly as much sense at times of moderate or low valuations. There has never been a big price drop that remained in place for any significant amount of time starting from a fair-value P/E10 level or a low-price P/E10 value. A price drop that only remains in place for a few years is not devastating for an age-55 investor. It might unsettle him. But so long as he will be able to recover from the loss well in advance of retirement age, he is better off sticking with a high stock allocation. He almost certainly will end up with a larger portfolio on retirement day that way than he would by retreating from stocks 10 years before his planned retirement date.

There’s another angle.

Those who are not close to retirement should also be aiming to avoid big losses at times of high stock valuations. It’s true from one way of looking at things that the aged investor suffers more from a big price drop because he does not have time to recover from it. From another way of looking at things, it is the young investor who suffers the most.

Young investors have more years in which to benefit from the magic of compounding returns. That means that in dollar terms younger investors take a bigger hit from price drops than do aged investors. Yes, they have more time to recover. But they also have more to recover from. Young investors lose not only the nominal losses but also decades of compounding on those nominal losses.

So the full reality is that aged investors are better sticking with high stock allocations at times of moderate and low prices and all investors (not only aged investors) should be going with low stock allocations at times of high prices. Should age then not be a factor that investors consider when setting their stock allocations?

I think age should be a factor. The error in the conventional wisdom is in overstating the importance of this consideration while understating the importance of valuations. At times of moderate valuations the relatively small consideration of whether the investor will have enough years before his retirement to recover from losses suffered looms more important.

Rob Bennett has written on what it takes to achieve an effective career change at 50, among other topics. His bio is here.